Financial Services Branch Financial Services and the Treasury Bureau 18/F Admiralty Centre Tower I 18 Harcourt Road Admiralty Hong Kong Attn: Consultation of Exemption of Offshore Funds from Profits Tax 19 February 2004

Dear Sirs

Consultation Paper on Exemption of Offshore Funds from Profits Tax

We refer to the Consultation Paper on Exemption of Offshore Funds from Profits Tax (the “Consultation Paper” or the “Proposal”) issued by your Bureau on 14 January 2004. We have addressed the four questions raised in the Consultation Paper in Appendix II to this letter, focusing on the practical and technical aspects of the proposed legislation, following extensive discussion with our clients and other industry participants. We also include our views on possible Government policy needed to address the overall needs of the fund management industry in Hong Kong and ensure that it remains a fundamental cornerstone of our financial services sector. The one month consultation period allowed to discuss the Proposal (which included the Lunar New Year holiday period), seems inadequate in the light of the many concerns being raised by industry participants and we would suggest that the envisaged timetable towards enacting legislation be revisited in order to allow for further debate following the close of this initial consultation period. General background We greatly welcome the Government's release of the Consultation Paper last month as we believe that the fund management industry is potentially a high growth sector of the economy, worthy of Government attention at the highest policy making levels. At PwC Hong Kong we place great importance on the fund management industry, serving approximately 160 fund management clients in this sector, as well as auditing almost 1,000 Funds1, most of which, to varying degrees have operations in Hong Kong. We believe that given a level playing field by regulatory and taxation authorities, the industry can grow to be substantially larger than that which is currently the case today. We also believe that hosting the fund managers, and the necessary infrastructure to support them, goes a long way to cementing the jurisdiction’s position as a leading global financial centre. In the context of the Asian region, Hong Kong must seize this opportunity, while it is in a position to do so, in the face of genuine and determined competition from Singapore (and in all future likelihood, other Asian cities). The release of this Consultation Paper represents an excellent opportunity for the Hong Kong Government to establish a pre-eminent position that would thwart any future challenge from other Asian capitals. 1

For the rest of the submission letter and appendices, “Funds” refers to investment fund(s) and collective investment scheme(s), and Offshore Funds are those Funds domiciled in jurisdictions other than Hong Kong.

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Financial Services Branch Financial Services and the Treasury Bureau 19 February 2004

Fund management is a talent business and an “added value” business. It is perfect for the Hong Kong of today and a fine example of where Hong Kong wishes to position itself for the future. The presence of increasing numbers of fund managers, resident in Hong Kong, establishing funds for Hong Kong and overseas investors, creates business for banks and brokers, accountants and lawyers, I.T. companies, landlords, Fund administrators, custodians and trustees, as well as auxiliary services. The benefits to the overall economy are clear to see as this is a sector that can create wealth and opportunity. New employment is created relatively easily as the barriers to entry in setting up a new fund management business are low when compared with many other types of business that require significant capital outlay. Direct fiscal revenues are created in many forms, such as salaries and profits taxes, licence and registration fees and stamp duty, as well as indirect revenues created through other parties. Recent years have demonstrated that the growth in start up boutique fund managers has been widespread globally, and that many of these firms have enjoyed a significant level of success in investment performance and asset growth, becoming substantial businesses. This trend must be encouraged as much of the experience to date suggests that the key beneficiaries are the Funds’ investors themselves. Why the Proposal will not boost the industry In order for the fund management industry to grow effectively in Hong Kong, there needs to be a high degree of certainty for fund managers and for their investors in relation to any potential tax liabilities of the Funds. The uncertainty which has been highlighted since the issuance of Profits Tax returns to some Offshore Funds is forcing fund managers to look at alternative jurisdictions and there is no doubt that Hong Kong has lost business in recent times, and will stand to lose a significant amount of funds business in the future, should a successful resolution not emerge from the current Hong Kong Government initiative. We believe that tests based on residency are not the appropriate criteria to be used in order to determine the taxability of an Offshore Fund. The key industry requirement of “certainty” does not result from the Proposal. In its current form, the Proposal seems unduly complex to operate in practice and our comments in the Appendices explore these difficulties in greater detail. As the Proposal currently stands, we do not believe that it will provide the impetus for the fund management industry to grow to anywhere near its potential. The current reaction of many clients is that this Proposal would make it impractical to accept any money from Hong Kong investors, whilst reducing the ability to raise as much money offshore due to the additional burden in certifying offshore investors to the satisfaction of the Inland Revenue Department (“IRD”). This “double negative” will force many fund managers away from Hong Kong, whilst forcing many Hong Kong high net worth or institutional investors to invest in overseas managed Funds. If such talented fund managers are to flourish in the Hong Kong financial infrastructure, it seems unfair to introduce a Proposal which does not result in a level playing field between Hong Kong investors and offshore investors. We need a resolution which allows sophisticated Hong Kong investors equal access to good investment products managed in Hong Kong in addition to currently available Securities & Futures Commission (“SFC”) authorised products which are targeted to the retail market. Preferred policy – blanket exemption for genuine and bona-fide Off-shore Funds © 2004 PricewaterhouseCoopers. All rights reserved.

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Financial Services Branch Financial Services and the Treasury Bureau 19 February 2004

We believe that in order to secure a pre-eminent position for Hong Kong, consideration should be given to granting a blanket exemption from Hong Kong Profits Tax to genuine and bona fide Offshore Funds that are managed in Hong Kong or are advised by an SFC approved investment adviser. Firstly, we consider it unlikely that the amount of Profits Tax which can be collected from such Funds (that exist today) is in any way significant in dollar terms. Secondly, this solution would dispense with the need for the application of what appears to be overly complex and practically unworkable rules set out in the Consultation Paper. These rules are very unattractive to fund managers, administrators and investors, due to the creation of uncontrollable uncertainties over a Fund's tax exposure together with a heavy administrative burden enforcing the residency rules. Thirdly, it would result in both overseas investors and those genuine Hong Kong investors in these Funds being treated equally. The inability of the manager to control capital flows may furthermore dictate that setting up new Funds that would have been managed from Hong Kong is too risky for fear of breaching the rules. We believe that such an exemption (which could theoretically be put in place for a limited number of years and thereafter be subject to review) would give potential fund managers some certainty in setting up business in Hong Kong, and allow the legitimate fund management industry already in place to flourish. The key features of such genuine and bona fide schemes, and hence the tests to pass in order to qualify for Profits Tax exemption, would be to satisfy the following criteria: •

the Funds must be managed by a professional fund manager or fund advisor entity (approved to the satisfaction of the SFC) who should be subject to periodic inspection by the SFC; and

•

the Funds should primarily consist of independent third party money (in effect to demonstrate that investors in the Funds do not control a related party investment adviser). Some special concessions should be granted to start up funds below a certain dollar asset value to recognise the normal practice of boutique fund managers providing seed capital to their own Fund.

Implications for “round-tripping” from the potential solutions The potential abuse by “round-tripping” is fully understood. However, from our experience we can say that the genuine and bona-fide Offshore Funds that we are aware of in Hong Kong are not the types of vehicle that are being used to avoid tax by Hong Kong investors. We believe that the provision of a blanket exemption to the genuine third party Funds would allow IRD resources to focus more clearly on cases where “round-tripping” might occur using existing anti-avoidance provisions in the legislation. In particular, we believe that taxability tests based on examining the independence of the adviser from the majority of investors in the Funds, will highlight attempts to take advantage of the exemption through “round-tripping” activities. Any genuine investment adviser should be able to demonstrate this fact of independence to the satisfaction of the IRD.

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Financial Services Branch Financial Services and the Treasury Bureau 19 February 2004

Specific tax concerns of Venture Capital / Private Equity Funds We note that the Proposal as currently drafted not only impacts the growing offshore hedge fund market, but also the Venture Capital / Private Equity Funds which may or may not have been the original intention. We suggest that the Bureau clarify if the intent behind the Proposal was to include Venture Capital / Private Equity Funds. Historically the Venture Capital / Private Equity Funds sector has been very active in establishing certain operations in Hong Kong, particularly in the case of pan-Asia funds. In our view, such “Venture Capital / Private Equity Funds” would generally satisfy the following criteria: (i) unless actively traded on a recognised stock exchange have an intended limited life, (ii) do not continuously raise capital, (but may call already committed capital) (iii) not be required to redeem shareholders interests upon investor requests, (iv) unless actively traded on a recognised stock exchange, must have a predominant operating strategy to return the proceeds of divestments to investors, (v) do not routinely acquire listed securities or derivatives as part of their investing strategy. From our experience and discussions with industry participants it is clear that the major concern of Venture Capital / Private Equity Fund managers is whether gains made from investments will be treated as capital or trading profits. It would appear appropriate now to clarify that for Venture Capital / Private Equity Funds meeting suitable criteria, profits arising from sales of portfolio investments are to be treated as capital gains. This would put Hong Kong on a level playing field with other major financial centres, such as the United Kingdom where a ruling (in 1989) by the UK Special Commissioners for Income Tax concluded that the business of a venture capital company was one of capital investment and not trading, as contended by the UK Inland Revenue. With the anticipated growth into the Mainland’s unlisted, less liquid securities and debt markets, this clarification would also be of tremendous benefit in promoting Hong Kong as the hub for investing into China. Overall conclusions on the Proposals In the appendices which follow, we have included detailed comments in respect of the Proposal, much of it highlighting the difficulties which would ensue, should the Proposal as currently drafted become law. To summarise, we would simply repeat our key conclusions, based on our many internal and external discussions on the Proposal over the last three weeks. 1. The Government’s ambition of creating an attractive environment for the fund management industry is the right policy, given the growth potential for this sector, the fiscal revenues which can be raised from housing the related infrastructure in Hong Kong, and for our overall reputation and credibility as a world-class financial centre. 2. Unfortunately, the Proposal does not meet the fund management industry’s need for a high degree of certainty in relation to an Offshore Fund’s potential taxation liabilities. If the legislation proceeds in a largely similar form to that set out in the Proposal, we have no doubt that this will be damaging to the prospects of building a stronger fund management community in Hong Kong.

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Financial Services Branch Financial Services and the Treasury Bureau 19 February 2004

3. We believe that the residency criteria should be replaced by an examination of independence and control factors that might exist between the approved investment adviser and the investors in the Funds, as the basis for determining when a Fund should be taxable. We believe that this will provide a stronger basis for the prevention of “round-tripping”. 4. Sophisticated Hong Kong investors should have an equal opportunity to invest in good quality investment products managed in Hong Kong in addition to existing SFC authorised products. Based on the current Proposal, the approved investment advisers would be very reluctant to accept any such onshore subscription money. 5. The time allowed for consultation has been a mere 4 weeks. Given what is at stake for the future of the fund management industry, we believe that more time is required to review the various submissions and consider alternative approaches, such as those we have tried to set out in this letter. We are happy to be part of the continuing debate, including the discussions of the meaning of “domicile” of Funds if the Bureau is prepared to consider the above key points. Our comments on the current Proposal If the Hong Kong Government cannot provide a blanket exemption for bona-fide Offshore Funds as proposed above, we would suggest that the current Proposal be amended to at least address some of the real tax concerns of the fund management industry, and to hopefully help further develop Hong Kong into the leading Asia ex-Japan fund management hub. Our comments on the current Proposal, should a blanket exemption not be given, are discussed in Appendix I to this letter. We hope that you find the above comments useful and we will be pleased to discuss any of the above points in more detail with you. Please contact either of the following industry partners below or visit our website for further information or clarification: Robert Grome Audit Partner Investment Management Industry Group Tel: 2289 1133 [email protected]

Florence Yip Tax Partner Investment Management Industry Group Tel: 2289 1833 [email protected]

Investment Management Industry website: http://www.pwchk.com/home/eng/fs_investmentmgt.html

Yours truly, On behalf of PricewaterhouseCoopers Limited Florence Yip Partner

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Appendix I

Our comments on the current Proposal Foremost, we strongly suggest that in order to achieve the Government’s ultimate goal in promoting and expanding the fund management industry in Hong Kong, the Bureau should consider granting a blanket exemption from Hong Kong Profits Tax to genuine and bona fide Offshore Funds. If the Bureau cannot provide such a blanket exemption for bona-fide Offshore Funds, we nevertheless provide below our views on how the Proposal would need to be amended to better address the tax concerns of the fund management industry, and therefore to provide the impetus needed to further develop Hong Kong into the leading Asia ex-Japan fund management hub. Consideration of section 20 of the Inland Revenue Ordinance (“IRO”) Before commenting specifically on the proposed section 20AB, we consider that it is vital for the Bureau to initially address certain terms and conditions under section 20AA of the IRO that we consider to be too restrictive, and not reflecting the commercial reality of the fund management industry. Accordingly, we suggest that the definition of the terms “associate” and “independent capacity” within section 20AA are both expanded and further clarified in order to ease the uncertainty that still surrounds the genuine and bona fide Offshore Funds being managed in Hong Kong. Regarding the proposed section 20AB, we consider that the test based on “residency” in the Proposal is not the most appropriate criteria for Funds in applying the proposed exemption. This criteria might make managers reluctant to accept onshore subscription money, thereby discriminating against sophisticated Hong Kong investors who we feel should have equal opportunities to invest in good quality investment products managed in Hong Kong, thus hindering the growth of the fund management industry in Hong Kong. Rather than using ”residency” test as a criterion, we suggest that independence and control tests may be more appropriate in determining whether a Fund is taxable, whilst providing a stronger basis in the prevention of “round-tripping”. In practice, many Offshore Funds may have a portion of its interests being owned by Hong Kong investors, but still should be regarded as Offshore Funds as they are operating on an arm’s length basis from those underlying investors. Besides, there is currently no definition of the term “resident” in the IRO. In order to provide certainty to the fund management industry, we suggest providing clear clarification of the term “resident” if that would become one of the criteria for determining whether the Offshore Funds would be tax-exempt in the new legislation. Application of a “residency” test In applying the proposed “residency” test, the Proposal states that amongst other criteria, an 80% “non-resident” threshold should be met for determining whether Offshore Funds are eligible for Profits Tax exemption. We understand that the proposed 80% “non-resident” threshold was arrived at by making reference to thresholds adopted in a number of other jurisdictions for determining partial or full tax exemption of Offshore Funds. However, in order to strengthen Hong Kong’s competitiveness as a major fund management centre in the region, we consider that the 80% “non-resident” threshold would not be sufficient to help the Government in promoting the industry as 80% is not a percentage that is more attractive than competing cities in the region, such as Singapore, from where we face genuine and determined competition. Furthermore, the proposed 80% “non-resident” threshold does not seem to address the unique nature of offshore boutique funds and start-up funds in which there are typically “seed” funds invested by the Hong Kong based manager and a small number of other investors to create a “track-record”. A manager launching a boutique fund would not yet know the future split between Hong Kong clients and nonHong Kong clients. With considered tax incentives, there is much potential for the growth of the industry on the back of these boutique funds and start-up funds that are considering being set-up, managed and having their investment advisory functions in Hong Kong.

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A fundamental issue when comparing the operations of an open-ended fund to tax legislation is the fact that tax only crystallised once a year, which can often not be anticipated due to imperfect knowledge on whether the fund would prove to be exempt. Due to fund redemptions and subscriptions being priced at a value without any anticipated tax liability, investors who have reaped the gains of a Fund’s performance may redeem their interest, leaving the remaining or new investors to bear any tax burden which may subsequently crystallise on a Fund not meeting exemption criteria. The tax status of a Fund must therefore be known to enable the proper pricing of Funds for subscriptions and redemptions so that innocent investors are not penalised. Related practical implementation difficulties we foresee include the potential confusion created by the unclear provisions of the Proposal, such as (i) how the Funds would be treated if they only temporarily breach the 80%:20% rule, and (ii) whether the Funds could still qualify for the Profits Tax exemption with retrospective effect to 1997 if they only satisfy the criteria from the effective date of the new legislation. Such uncertainty may also force non-Hong Kong investors to redeem their investments in Hong Kong managed Funds to protect them from possible taxation liabilities caused by unrelated Hong Kong investors investing in the same Fund. Administrative burden Another major concern of industry participants considering the proposed legislation is the anticipated practical difficulties and costs of implementing the provisions of the proposed legislation. The dominating practical implementation issue is the administrative burden involved for the brokers / investment advisers (and possibly Fund administrators) in complying with the proposed record-keeping requirements. This burden seems enormous and practically unrealistic to be carried out and complied with. Three examples of such practical burdens are (i) open-ended funds where investors constantly change due to subscriptions and redemption of investments at different times of the year; (ii) fund-of-funds, whose investors would be funds or layers of funds where the ultimate investors are difficult to identify; (iii) certain trusts whose beneficiaries do not even have knowledge of their respective entitlement. As a result of the compliance burden, Funds and fund managers will certainly be discouraged from basing their fund administration and investment advisory functions in Hong Kong. Exemption for listed Funds A point for consideration not included in the Proposal is a request that the SFC increase the number of acceptable regulatory authorities listed in Appendix 1A of the SFC’s Code of Unit Trusts and Mutual Funds in order for more genuine and bone-fide Funds, including those listed on the Hong Kong Stock Exchange which are not authorised by the SFC, to avail the tax exemption under section 26A(1A) of the IRO. Concluding comments on the Proposal In conclusion, considering the impracticability of the proposed anti-avoidance provisions in the Proposal and the high degree of uncertainty that would still surround the fund management industry, we believe that granting a blanket exemption from Hong Kong Profits Tax to Offshore Funds is the most effective way in boosting the fund management industry, and in doing so satisfying the Government’s long standing objective in attracting Offshore Funds to Hong Kong. The Proposal is too prescriptive and does not correlate with either of the Government’s objectives of promoting the fund management industry in Hong Kong, or in bringing Hong Kong in line with other major international financial centres. Implementation of the Proposal as drafted will not only not satisfy the Government’s objectives, but would possibly drive fund managers away from Hong Kong to other jurisdictions in Asia, as well as causing overseas investors to redeem existing investments in Hong Kong managed Offshore Funds.

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Appendix II

Question being addressed (a) As far as tax incentives are concerned, do you agree that the proposed legislation is sufficient for attracting Offshore Funds to Hong Kong and enabling Hong Kong to compete with other countries with similar exemptions on a level playing field? If not, why not and what other aspects do we need to consider? PwC Response Whilst the tax incentives as currently drafted seek to address the concerns of some fund managers, we believe that they are not adequate to remove those concerns or to achieve a level playing field for Hong Kong in promoting the growth of the fund management industry. Particular points connected with this are listed below, together with our subsequent suggestions on dealing with these issues under question (c) in Appendix II: Consideration of periodic capital flows 1. Due to the nature of an open-ended Fund, investors can redeem their investments at each dealing date, ensuring that the fund manager cannot control the ratio of Hong Kong clients and non-Hong Kong clients. The proposed wording does not currently give guidance on how any “temporary” breaches of the 80%: 20% rule will be treated, and seems to imply that a Fund is subject to tax for a whole year even if the 20% threshold is breached for one day. The United Kingdom is an example of a jurisdiction where compliance over a period of time, rather than at a point in time is applied. Providing certainty to prospective managers 2. The 80%: 20% rule does not give sufficient certainty for a prospective manager to commence operations in Hong Kong, as the source of future funding would not be certain. In the case of a prospective boutique fund manager, it may appear safer to avoid Hong Kong investors and/or trading in Hong Kong securities due to these uncertainties. Two practical illustrations of this point are (i) where there is a “seed investor” in Hong Kong whose initial significant holding will only be diluted over some years as the Fund grows, and (ii) where a prospective Fund is launched by a Hong Kong based manager who does not yet know the likely split between Hong Kong clients and non-Hong Kong clients. 3. The 80%: 20% rule as drafted does not give exemptions for new Funds whose Hong Kong clients to non-Hong Kong clients ratio will be volatile in the early years while the Fund is being actively marketed. Special exemptions for new Funds will give more confidence to managers considering starting up business in Hong Kong. Impact of ratio on genuine Offshore Funds 4. For existing or proposed Funds, the proposed 80%: 20% ratio seems overly burdensome on clients in determining if they are bona-fide Offshore Funds which should be able to claim a tax exemption. Many Funds may have over 20% of its capital owned by Hong Kong clients, but still should be regarded as Offshore Funds as they are operating on an arm’s length basis from those underlying investors. If a blanket exemption is not given, a revised ratio and / or a requirement based on an arm’s length asset managers would be more appropriate.

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Other non-taxation aspects for the Bureau to consider The issue of Hong Kong Profits Tax potentially being levied on Offshore Funds is a major concern of managers when considering jurisdictions in which to set up business, but there are other matters listed below that we believe that the Bureau should also take into consideration. The matters listed below are matters which we discussed with influential industry participants during an industry round table hosted by PwC in May 2002, and are relevant to the Government’s overall policy objectives. Some of the action points raised at this round table are listed below: •

• • •

• • •

Increase resources at the SFC to assist in reducing the delays for potential new investment advisors and managers being licensed. Currently Singapore is viewed as far more responsive in processing licensing applications to enable new Funds to start operating within a reasonable timeframe. Further develop the concept of “passporting” within the Asian region, and specifically support the distribution of Hong Kong managed Funds to Mainland China investors. Promote the ease of cross border capital flows involving investors and Funds entering into the Mainland market. Increase the penetration rate of retail products through greater investor education. The Hong Kong market is still viewed as immature compared to established markets. Progress has been made to date, particularly with the marketing of MPF products and the authorization of hedge funds and fund of hedge funds by the SFC. Incentives for basing fund administration and transfer agency functions in Hong Kong. Encourage Hong Kong as a place of domicile for Funds. However, in order to attract Funds to be established in Hong Kong, it may require changes to several ordinances, for example, the Companies Ordinance, the Stamp Duty Ordinance and the Estate Duty Ordinance. The creation of “Boiler-Plate” listings to enable a more efficient process for Funds to be listed on the Hong Kong Stock Exchange.

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Question being addressed (b) Do you think the proposed anti-avoidance provisions in section 20AB(2) are effective in preventing round-tripping of local Funds from taking advantage of the tax exemption? If not, why not and what other elements should be included? PwC Response As far as the proposed anti-avoidance provisions in section 20AB(2) are concerned, the Proposal provides that the proposed exemption for Offshore Funds would not apply if the following conditions cannot be met: (i) At least 80% of the Offshore Fund is beneficially owned by non-residents; and (ii) The Offshore Fund and its non-resident investors do not carry on any other business in Hong Kong. Certain prerequisites required under section 20AA before the application of the proposed section 20AB(2) can be made The proposed provision in section 20AB(1) states that the exemption for Offshore Funds would apply only if section 20AA of the IRO is satisfied. Under section 20AA, there is a requirement that investment transactions are carried out by a broker or an approved investment adviser who meets certain conditions. The current conditions with respect to transactions carried out through an approved investment advisor require the satisfaction of both the “associate” and “independent agent” prerequisites. While we welcome the Bureau in confirming that compliance with section 20AA would ensure Offshore Funds are not carrying on business in Hong Kong, we suggest that the Bureau should consider loosening the interpretation of section 20AA, in particular the definition of “associate”. In addition, the Bureau should also clarify the definition of “independent capacity”. We suggest that an amendment to the definition of “associate” under section 20AA is necessary since the section 20AA exemption does not currently reflect the realities of the fund management industry. For example, it is not uncommon in the fund management industry that certain Offshore Funds have their own ”appointed” approved investment advisers, where their approved investment advisers could be related associates but are in fact acting in an independent capacity on behalf of the Funds, and receiving remuneration from the Funds on an arm’s length basis. In such a case, under the current definition of section 20AA of the IRO, the approved investment adviser would be considered an associate of the Fund. In view of the above, we suggest that those approved investment advisers could be precluded from being considered as an associate for the purposes of section 20AA, but not for other parts of the IRO, in the following circumstances: (i) the approved investment advisers are acting for the Offshore Funds in an independent capacity, in the ordinary course of business and receiving remuneration on an arm’s length basis; and (ii) the approved investment advisers and Offshore Funds may have common shareholders and / or directors, but those shareholders and / or directors do not hold the majority of the beneficial interest in the Funds.

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There is a requirement of providing services in an independent capacity which must be satisfied with respect to approved investment advisers, outlined in section 20AA(3)(g), which provides that the approved investment adviser, when he acted for the non-resident person in a transaction, did so in an independent capacity. The term “independent capacity” is currently not defined under the IRO. The Bureau may consider to make reference to the UK Inland Revenue Statement of Practice 1/01 which sets out scenarios on how the UK Inland Revenue would apply the independence test, provided the manager (an approved investment adviser in the case of Hong Kong) satisfies the other provisions of section 127(3) of the UK tax law. We would also like to point out that under the current section 20AA of the IRO, the definition of an “associate” in relation to a non-resident person covers a natural person, corporation, partnership, but does not cover a trust. Having considered the above, we recommend that the Bureau consider broadening the practical application of section 20AA, clarifying the definition of “independent capacity”, and relaxing the definition of “associate” under section 20AA. In view of these contentious issues involved, we would recommend that the Bureau provide guidance by way of the IRD issuing a Practice Note rather than legislative amendments. Clarity on the terms “residency” and “carrying on business in Hong Kong” used in the proposed section 20AB With respect to the proposed anti-avoidance provisions, we feel that the industry needs clear definition of all terms which may impact their taxable status. The most significant term for determining the eligibility of an Offshore Fund for exemption will be the term “resident”. We consider that further clarification of the term “resident” is required since the IRO does not currently have a definition for it. Whilst we support the view that relevant anti-avoidance provisions are essential, we note that currently a vast number of genuine bona-fide Offshore Funds that are managed or have investment advisory functions in Hong Kong are not only unlikely to be able to enjoy the benefits of the proposed legislation, but will be forced from Hong Kong by it, especially due the failure to meet the 80% “non-resident” threshold. We suggest that the Bureau consider amending the anti-avoidance provisions to a certain degree in order for the Government’s policy objectives to be met. For our comments in this regard and suggestions of other possible areas of consideration in relation thereto, please refer to our response to question(c) below for further details. As a related matter, under section 20AB(2)(a) of the proposed anti-avoidance provision, profits tax exemption would not be available if the non-resident person is carrying on another trade, profession or business in Hong Kong in addition to transactions through brokers or approved investment advisors falling within section 20AA (“the requirement of not carrying on any other business in Hong Kong”). In general, a person could be regarded as carrying on trade, profession or business in Hong Kong either directly or through an agent, or being deemed to be so. We suggest that clarification has to be made, for example, as to whether a person derived certain sums which are regarded as deemed trading receipts under section 15(1) of the IRO would be considered as carrying on trade, profession or business in Hong Kong under the proposed legislation. As such, the Bureau may want to specify in the proposed legislation that a person who merely derives amounts deemed to be trading receipts under section 15(1) of the IRO should not be considered as carrying on business in Hong Kong for the purpose of the proposed section 20AB.

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In addition, we understand that in order for Funds to be eligible for the profits tax exemption under the proposed legislation, one of the requirements provides that “the non-resident persons should not carry on any other business in Hong Kong”. Confusion arises as to which persons this requirement is applying to within “a chain of intermediaries” of typical Funds. We suggest that the Bureau clarifies that the above requirement is only confined to the Fund itself and its immediate investors.

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Question being addressed (c) Do you consider the 80% threshold in section 20AB(2)(b) reasonable? If not, why not and what is the threshold you consider appropriate? PwC Response Comments on the threshold criteria The proposed legislation requires among other criteria that the Offshore Funds should be beneficially owned not less than 80% by non-residents in order to qualify for the proposed Profits Tax exemption. We consider that the 80% threshold is essentially impractical and is not sufficient in helping the Government in strengthening Hong Kong’s competitiveness as a major fund management centre in the region, as many bona-fide Offshore Funds would not be able to meet this requirement. In order to achieve the Government’s objective to reinforce the status of Hong Kong as an international financial centre, one may expect that if a blanket exemption for bona-fide Offshore Funds is not to be introduced, that a much lower threshold is implemented and suggest that it would be more appropriate to have the 80% threshold reduced to at least 51% in order to lower the negative effect of the proposed legislation on the fund management industry. In other words, the Offshore Funds would need to be beneficially owned not less than 51% by nonresidents, provided that other criteria are met, in order to qualify for the proposed Profits Tax exemption. For your information, in Singapore, specified income derived by foreign investors in respect of any designated investments from Funds managed by any fund manager in Singapore or as a result of investment advisory services provided by any fund manager in Singapore have been exempt from all tax with effect from 3 May 2002. A foreign investor refers to a company not being resident in Singapore where not more than 20% of its issued share capital is beneficially owned, directly or indirectly, by persons who are citizens of Singapore or resident in Singapore. As such, in order for Hong Kong to be a more attractive and competitive place for the fund management industry than other jurisdictions in the Asia Pacific region, if a blanket exemption is not given, we would suggest that the Bureau should consider lowering the threshold, to at maximum 51%, in order to qualify for the proposed exemption. In addition, as mentioned in the proposed legislation, “…… if at any time during the year of assessment, the stake in the corporation, trust estate or partnership of non-residents who have not carried on any transaction, profession or business in Hong Kong involving any transaction other than a transaction described above in that year drops below 80% (currently we consider nil, or at most 51% being more appropriate).”, the Offshore Funds will not be eligible for exemption under the proposed legislation. In other words, even if the stake of an Offshore Fund meets the threshold requirement during most of the time in an assessment year but drops under the required threshold during any day of the assessment year, the Offshore Fund would be excluded from the proposed exemption. We consider that the lack of an appropriate grace period for the Offshore Fund to correct the stake percentage to the required threshold as being too prescriptive and unreasonable in practice. In this regard, we suggest to make reference to the UK exemption law whereby it applies the exemption test over a qualifying period of up to 5 years. Under the current UK Investment Manager Exemption Law, the requirement is that the investment manager and persons connected with the manager must not be beneficially entitled to more than 20% of the Fund’s taxable income arising from transactions carried out through the investment manager. In order to allow for the © 2004 PricewaterhouseCoopers. All rights reserved.

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common commercial practice of Offshore Funds to have heavy seeding by their investment management organisation in the UK, to provide an initial track record, and to provide investors with an established Fund in which to invest, the calculation of the 20% test is applied to the average percentage of entitlement by the investment manager in the Fund’s taxable income over a period of up to 5 years. Reference could be made by the Bureau to apply the mechanism of using the average percentage over a period of time to the proposed legislation so as not to penalise the Offshore Funds having the intention to keep the beneficial ownership of non-residents over the threshold but fail to do so in certain periods of the assessment year. The Offshore Funds could be required to keep the average percentage of beneficial ownership of non-residents in the Offshore Funds over a threshold over a period of time. As 5 years may not at all be practical to apply in Hong Kong, a period of 24 months could be adopted. However despite this being more reasonable in principle, the increased administrative burden would be cumbersome to apply in practice and a blanket exemption is viewed as a better solution to meet the Government’s policy objective. Practical difficulties In the case where the Offshore Fund is a corporation, in order to determine the beneficial ownership of the investors, it is proposed that the Government will look at the issued share capital of the Fund. In connection to the above, we are anticipating clarification from the Government on what the “issued share capital” refers to. Offshore Funds set up as corporations are normally structured with more than one class of shares (e.g. ordinary voting shares and participating nonvoting shares). We consider that the Bureau should shed some light on how the threshold should apply; whether to the entire number or the amount of issued share capital of the Fund regardless of its classes, or only to a particular class of ordinary or participating shares. We believe that ownership should be based on the participating shares, as these have the beneficial economic interest in the Fund. In addition, implementing Schedules 13 and 14 of the Proposal would create enormous difficulties for the relevant parties in tracing the non-resident status of the investors. Examples are provided below for instances where this would be the case: (i) an overseas pension fund whose ultimate beneficiaries are employees of a corporation with possible high turnover of employees over a period; (ii) a discretionary trust whose deed provides that the distribution of profits is up to the discretion of the trustee with the beneficiaries not having knowledge of their respective entitlement; (iii) an overseas listed company whose stocks are being traded publicly on stock exchanges; and (iv) fund-of-funds, whose investors would be funds or layers of funds, would find it difficult to identify the ultimate investors. Limitation on Hong Kong Profits Tax exposure Should an Offshore Fund not be able to meet the requisite “non-resident” stake percentage after the lapse of the stipulated period, we suggest that the taxable portion of the Offshore Fund’s income be computed only in proportion to the stake percentage of the Hong Kong resident investors. Whilst this would be very burdensome to administer, this would ensure that nonresident investors would be more comfortable investing in a Hong Kong managed Offshore Fund.

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Furthermore, the Offshore Funds should not be taxed retroactively but should be taxed from the taxation year immediately following the year of the breach. Start-up funds As a suggestion to strengthen the fund management industry in Hong Kong, we suggest to provide a special tax exemption to the growing sector of offshore boutique funds and start-up funds as these funds will attract fund managers and other management functions using Hong Kong as the base for their operations. In order to promote the establishment of offshore boutique funds and start-up funds being managed and having investment advisory functions in Hong Kong, the Bureau may consider offering specific exemptions to these start-up funds for tax incentive purposes. We propose that if there is no blanket exemption, Offshore Funds with start-up capital of no more than US$5 million would be exempt from Hong Kong Profits Tax for their first three accounting periods since establishment (“the grace period”) even if they cannot satisfy any applicable threshold requirements. During the grace period, the Offshore Funds should be allowed to correct the situation by attracting more non-resident investors in order to dilute the beneficial ownership of the Hong Kong residents. If the Offshore Funds still cannot achieve the required threshold at the end of the grace period, the exemption will be withdrawn and the Offshore Funds become liable to tax starting from the first day of its fourth accounting period.

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Question being addressed (d) Would you have difficulty in complying with the record-keeping requirement options set out in paragraph 15? If yes, please provide details about the difficulties and your other suggestions which can achieve the same purpose. PwC Response Practicability of the record-keeping requirements The proposed legislation provides that, for monitoring and to combat abuse, sufficient records should be kept by the brokers / investment advisers in order for the IRD to verify the non-resident status of the investors on which the Offshore Funds rely on for claiming exemption under section 20AB(1), and that the exemption threshold referred to in section 20AB(2)(b) has been met. While we agree that the brokers / investment advisers should to a certain extent comply with the recordkeeping requirements and provide records when requested by the IRD, we suggest that the proposed compliance burden on the brokers / investment advisers with the record-keeping requirement should be reduced. If the brokers / investment advisers are required to keep records to verify the non-resident status of the investors of the Offshore Funds, with the definition of “residence” being unclear, the administrative burden would be enormous and it may be practically unrealistic to be enforced, particularly where there could be changes to the composition of the shareholding of Offshore Funds during any time of the year as a result of subscriptions and redemptions by investors. In this regard, we suggest that the onus should be on the immediate investors (who hold the beneficial interest in Offshore Funds) to make a simple declaration, and then all concerned parties (including brokers, approved investment advisers, custodians, administrators and other intermediaries) should be entitled to rely on that declaration in good faith. Retrospective effect We understand that the proposed section 20AB aims at granting Profits Tax exemption retrospectively from 1 April 1997 to Offshore Funds, provided certain conditions are met in respect of any income derived from transactions undertaken in Hong Kong through an agent who is a broker or an approved investment adviser falling within section 20AA of the IRO. Whilst we support that relevant provisions should have retrospective effect, the proposed legislation does not indicate clearly whether the Funds have to satisfy the requisite conditions since 1 April 1997; or as long as the Funds meet all the requirements as at the effective date of the new legislation, they can automatically enjoy the profit tax exemption from 1 April 1997 no matter whether they can satisfy the requirements from 1 April 1997. In view of this, we suggest that the latter should prevail (i.e. the Offshore Funds should be able to enjoy the exemption retrospectively from 1 April 1997 provided they can satisfy all the conditions as at the effective date of the new legislation) for the following reasons: (i) The investors of the Offshore Fund who would bear the tax would probably not be those who enjoyed the profits and already redeemed their shares. There may be a mass run of redemptions on Hong Kong managed Offshore Funds in order to liquidate positions before any possible tax liabilities crystallise.

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(ii) The Offshore Funds / brokers or approved investment advisers may not have kept the records of investors of the Funds (e.g. their residence, the percentage of holding, etc.) that date back to prior years, especially those dating back more than seven years ago to 1 April 1997. As there could be vast changes to the composition of the direct and indirect shareholding of the Funds (especially in the case of open-ended funds) during any time of the year, as a result of subscriptions and redemptions of investments made by investors, there creates a considerable administrative burden to the Funds / brokers or approved investment advisers if they were required to provide such information that relates to prior years. (iii) The Securities and Futures Ordinance (“SFO”), enacted on 13 March 2002, consolidates and streamlines the 10 ordinances which regulated the securities and futures markets which were written over a period of nearly 30 years. Technically, the fund management industry may be confused as to which Ordinance / 10 ordinances to follow if there is discrepancy, say in wordings, between the SFO and the 10 ordinances since 1 April 1997. Meanwhile, we respectfully request the Bureau to consider advising the IRD to continue withholding any potential action to be taken on the fund management industry until the new legislation on the exemption of Offshore Funds is put into place. Proposed confirmation form We refer to the draft confirmation form (“the Form”), created for the purpose of recording residency for determining the eligibility for Profits Tax exemption under the proposed legislation (see Appendix III), which was prepared by the Bureau subsequent to the issuance of the Consultation Paper. We note the following deficiencies which we would like the Bureau to address: (i) The Form, including Footnote 2, does not provide clear definition of residency. (ii) Item 1 of the Form seems to imply that an investor who completes the Form knows in advance that all of the requirements in section 20AB relating to investors, Funds, other investors, broker or approved investment adviser have been met. This is not practically possible. (iii) Footnote 1 of the Form requires an investor to review section 20AA of the IRO and the proposed section 20AB in the IRD website. This is not user friendly, particularly to those who are not familiar to tax legislation. (iv) The Form does not specify as to whether a direct or an indirect investor should be completing it. (v) Item 2 of the Form requires the investors to inform the IRD in case of any change in circumstances that might affect the exemption granted. This appears to be inconsistent with the fact that the original Form after completion was forwarded by the investor to either the broker or approved investment adviser, rather than directly to the IRD. (vi) It is common that a Fund would be recommended by a bank to its institutional and high net worth clients. The investment would usually be channelled through a nominee or custodian company in the bank group. The broker / approved investment advisor only deals with that nominee / custodian company as client. It is unclear as to whether it is sufficient for this form to be completed and signed by the investment nominee / custodian company only.

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In essence, we suggest that the Form needs to be simplified along the following lines: (i) Item 1 should be amended as follows: “This is to confirm that the following person (for natural persons investors) to the best of his / her knowledge that he / she is a non-resident of Hong Kong; (for other types of investors) to the best of its knowledge that it does not carry on any business in Hong Kong.” (ii) Definition of a “non-resident of Hong Kong” should be included in the Form. (iii) For an investment nominee / custodian company investing in a Fund on behalf of its clients, it should request its clients to complete the Form.

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Appendix III

Confirmation of Eligibility for Profits Tax Exemption under Section 20AB(1) of the Inland Revenue Ordinance This form is to be completed by the non-resident client of a Hong Kong broker/approved investment adviser who is required to keep the form as part of his business records. (1) This is to confirm that the following person is a non-resident of Hong Kong who has met all the requirements laid down in section 20AB1 of the Inland Revenue Ordinance (“IRO”) for profits tax exemption in Hong Kong. Name of Non-Resident Address Place of Incorporation /Country of Residence2 Name and Address of the Hong Kong Broker /Approved Investment Adviser Account/Reference number with theBroker/Approved Investment Adviser (2) In case of any change in circumstances that might affect the exemption granted, we undertake to inform the Inland Revenue Department of Hong Kong within a month of the occurrence of such event.

Date:__________________________

Signature:________________________

Telephone:_____________________

Designation3:______________________

1

2

3

The provisions of sections 20AA and 20AB can be viewed in the website of the Inland Revenue Department {xxxxxxxx} In case of an incorporated body, please fill in the place of incorporation. For other cases, please fill in the country of residence. To be completed by a responsible officer e.g., director, company secretary, general manager of the nonresident person.

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